What you need to know about ETFs

Over the past few years, exchange-traded funds have taken the investing world by storm.

Not familiar with ETFs? You should be. These funds have been around since 1993, but in recent years they’ve been drawing investors with a vengeance and have grown exponentially.

Consider that in 2006, net assets in ETFs totaled $432 billion. By February of this year, that had ballooned to $1.2 trillion, according to Morningstar, an investment research company.

“There have been a lot of investors turning to ETFs,” said Michael Iachini, managing director of ETF Research at Charles Schwab Investment Advisory Inc. “ETFs do offer some nice benefits.”

So just what is an ETF and what do you need to know to invest in one?

Simply put, ETFs are investment funds that trade throughout the business day like stocks. You may buy or sell ETF shares through a stockbroker just as you would the shares of any publicly traded company.

“ETFs are basically index mutual funds that trade like stocks,” Iachini said. “When you buy an ETF, you own a single security that represents a basket of other securities, generally tracks an index and fluctuates with the value of the underlying assets.”

Among the benefits of ETFs are:

Lower expenses: Most ETFs have lower costs than comparable mutual funds. One way to evaluate an ETF’s cost is to look at its expense ratio.

“Expense ratios are the percentage of the fund’s assets that the manager takes each year to cover their costs, and these tend to be really, really low for ETFs,” Iachini said.

That’s because ETFs are usually index funds.

“Index investing tends to be very inexpensive because you don’t have to hire a team of analysts or build some expensive quantitative model to decide what stocks or bonds to buy,” Iachini said. “You just buy all of them in an index.”

Specialized investments: Investors interested in a particular industry, commodity or country can gain access through an ETF.

“They may like a particular country or industry, and an ETF will usually be available to implement exactly that idea, but still give them diversification,” Iachini said. “It’s not like you’re buying one stock in an industry or one stock in a country. You’re buying an ETF that has dozens and sometimes hundreds of stocks in that industry or that country.”

While there are mutual funds that invest in broad emerging markets or broad commodity indexes, “some investors are looking for exposure to a specific commodity [gold, oil, etc.] or a specific emerging market country [Brazil, Russia, etc.],” he said.

“In many cases, there are no mutual funds that invest in these specific niches,” Iachini said. “Furthermore, mutual funds that invest in exotic asset classes tend to have very high expense ratios. ETFs are much more competitively priced in general.”

Tax efficiency: Because most ETFs are engaged in index investing, they’re not continuously buying and selling stocks to try to beat the market. That benefits ETF investors because they have less likelihood of incurring capital gains, which are taxed.

Trading flexibility: For investors who want to trade frequently, ETFs have an advantage over mutual funds because they trade throughout the day.

“With a mutual fund, you get to trade it once a day, basically at the close of market,” Iachini said.

To get started with an ETF, contact your broker. Some mutual funds, including Vanguard and Fidelity, also offer ETFs.

But despite the many benefits, don’t invest in an ETF — or any investment — until you’ve decided what role it would play in your investment goals.

“Make sure the ETFs you’re considering are invested in the right part of the market,” Iachini said. “Digging deeper to look at a fund’s actual holdings is also a good idea. ETFs that initially seem similar may actually be very different.”

Other things to consider are:

Check the costs

There are three costs to consider:

Operating expense ratio: This is the ongoing cost that the ETF manager charges for overseeing the portfolio. It’s expressed as a percentage of the fund’s average daily net assets.

“If you plan to hold an ETF for a long time, when it comes to costs, you want to focus on that expense ratio because that hits you every single year, rather than the trading cost [which] is only paid when you trade it,” Iachini said.

“Costs for U.S. large-cap ETFs can be in the neighborhood of 0.1 percent, whereas actively managed mutual funds in the same space can be 1 percent or more,” he said.

Bid/ask spread: This is essentially the difference between the highest price that a buyer is willing to pay (the bid) for an asset and the lowest price for which a seller is willing to sell it (the ask).

For example, say the bid price on an ETF is $25.10 a share, while the ask price is $25.14 a share.

“That would be a 4-cent spread between the bid and the ask,” Iachini said. “You don’t want to trade an ETF with a wide spread.”

But what constitutes a wide spread is relative. “A 5-cent spread might be OK on a $100 ETF, whereas it might be unacceptably wide for a $10 ETF,” Iachini said.

In general, the lower the spread, the better, he said.

Commissions: Because ETFs trade like stocks, your broker will usually charge you a commission for each trade.

“You may be able to get some ETFs commission-free, which can be a benefit in the cost analysis, especially if you’re making a small investment or if you don’t plan to hold the ETF for years,” Iachini said.

Check the track record

Again, there are three areas you want to examine:

Performance: Look at a performance chart that compares how well the ETF performed, compared with the index it’s tracking.

“You want to look at how much the ETF’s performance has matched its benchmark,” Iachini said.

Assets: If the ETF doesn’t have at least $20 million in assets, it might eventually be closed by its sponsor, Iachini said.

Trading volume: “If an ETF is very thinly traded [less than $500,000 worth of shares changing hands every day], it’s more likely to have wider bid-ask spreads,” he said.

Investors also should look at the strength of the company behind the ETF. Look for stable management and a clean record with regulators.

Bottom line: ETFs may or may not be the right investment for you. Don’t let their popularity lead you to invest before you determine whether ETFs would be compatible with your investment goals.

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